From the foundation of a strategy, each company must develop a tactical action plan to execute its strategy. As a best practice, we see companies broadly follow these steps:
1. Determine objectives, priorities, and constraints. Common examples are to enhance liquidity and debt capacity by reducing the volatility of funds from operations, improve transparency of operating performance, or to reduce the chance of an adverse event.
2. Establish relevant risk guidelines. Identify maximum tolerable amount of positioning (e.g., all hedges serve a business purpose, no new risks or exposures will be created, hedge ratio tolerance ranges). Centralize decision making to avoid double hedging, facilitate risk netting, and improve bank bids. Evaluate potential conflicts with all incentive compensation programs.
3. Assess net exposure to be hedged. Define, measure and analyze all exposures to be managed, paying particular attention to any correlations and natural hedges. Determine the extent to which each exposure needs to be hedged and can reasonably be hedged, as well as the main attributes of the hedging program (e.g., hedged exposures, hedge horizon, hedge amounts, and hedge ratios).
4. Compare suitability of various hedging tools. Determine how various hedging tools (i.e., options, swaps, and forwards) are to be incorporated into the program to meet stated goals, views, and risk preferences for each exposure. Assess the pros and cons of hedging instruments, beyond simple ...